The Journal Report

But beneath the surface is a treacherous landscape of potential trading problems that can raise costs for individual investors.

The ease of buying and selling ETFs, which typically resemble index-tracking mutual funds but trade like stocks, has helped make them the darlings of investors big and small. But as ETFs delve into more esoteric areas of the market such as high-yield bonds and commodity futures, trading them has become more complex.

Also contributing to problems with liquidity—or the ease with which these products can be bought and sold without big trading costs—are things like regulatory scrutiny, strong investor demand for certain ETFs and the fact that many of these funds now launch with the bare minimum level of assets—often just $2.5 million or so.

There are “a lot of dissatisfied customers” discovering snags in ETF trading, says Scott Burns, director of ETF research at Morningstar Inc.

A lack of liquidity can lead to wide “bid-ask spreads,” or the gap between the price buyers are willing to pay for shares of an ETF and the price sellers are asking. The wider the spread, the bigger the bite taken out of investors’ returns every time they buy or sell. A lack of liquidity also may cause the ETF to trade at a large premium or discount to net asset value, or NAV—the value of the fund’s underlying holdings. That means an investor buying the fund may overpay for that portfolio, or an investor selling could get less than that basket of securities is worth.

These issues haven’t stopped investors from flocking to ETFs, however. Assets in U.S.-listed exchange-traded products totaled $791 billion at the end of December, a 47% jump from a year earlier. ETF trading volume, meanwhile, averaged 1.9 billion shares a day in 2009, up 20% from a year earlier, according to the National Stock Exchange.

To size up an ETF’s liquidity, investors need to examine the fund’s underlying holdings as well as the ETF shares themselves. Here’s a look at the major points to consider before buying or selling an ETF, as well as some tips on trading these funds smoothly and cheaply.

How Are the ETF’s Shares Trading?

A glance at an individual ETF’s trading volume or bid-ask spread doesn’t tell the whole liquidity story, but it offers key information for investors.

ETF assets and trading volume are highly concentrated in just a handful of funds. The 10 largest ETFs account for almost 40% of total ETF assets, while the 10 funds with the largest dollar trading volume accounted for roughly 60% of the total volume for all ETFs in December, according to National Stock Exchange.

Investors trying to buy or sell these ultrapopular ETFs probably won’t run into problems. Consider the SPDR, which tracks the Standard & Poor’s 500-stock index. Almost 3 billion SPDR shares changed hands in December, according to NYSE Arca, with an average bid-ask spread of just a penny.

One problem is that market makers—those who help maintain orderly trading in ETFs—get rebates from exchanges that are calculated on a per-share basis. Thus, they may not have much incentive to maintain relatively narrow gaps between bid and ask prices in funds with very low trading volume.

“We’re not happy” with how the Claymore U.S. Capital Markets Bond ETF is trading, says Bill Belden, managing director at Claymore Securities Inc. In discussions with the exchange and market makers, he says, “we continue to push for more efficient pricing” in the fund.

Spreads of more than five to 10 cents “would concern me,” says Matt Hougan, editor of IndexUniverse.com. “If it’s 50 cents, I would run screaming.” More than 300 of the roughly 800 ETFs trading on NYSE Arca in December had average spreads of more than five cents, while six had spreads of more than 50 cents.

Other problems can arise when an ETF has to suspend issuing new shares. Specifically, big gaps can develop between the ETF share price and the value of its underlying holdings.

In some cases, regulatory scrutiny sparks the problem. In late August, for example, BlackRock Inc.’s iShares unit announced that it had suspended creation of new shares of its iShares S&P GSCI Commodity-Indexed Trust ETF amid concern that the Commodity Futures Trading Commission might limit the size of firms’ positions in various commodity futures. The fund began trading at a significant distance from its NAV, including a roughly 4% premium on Oct. 1, though the gap has narrowed recently.

Sometimes ETFs offer only a limited number of shares and require regulatory approval to issue more. In such cases, investor demand can outstrip this supply. That’s what happened to PowerShares DB US Dollar Index Bullish fund, which had to suspend creation of new shares in December for the second time in two months because of voracious investor appetite for the product. It resumed issuing shares on Jan. 5.

How Are the Underlying Holdings Trading?

While it’s important to look at how ETF shares are trading, the fund’s underlying holdings are really the heart of the liquidity issue, experts say.

One reason: Big investors known as “authorized participants” can swap a basket of the fund’s underlying holdings for ETF shares—or vice versa. This process helps arbitrage away significant gaps between the ETF’s share price and its NAV, the value of its underlying holdings. But when the underlying holdings are costly to trade and tough to obtain, authorized participants are less willing to round up that basket of securities. That means big gaps can develop between an ETF’s share price and its NAV.

One place to watch out for these premiums and discounts is in bond ETFs, especially those focused on areas like corporate investment-grade and high-yield, or “junk,” bonds. The closed within 0.5% of NAV on only four days in the fourth quarter, iShares says, and traded at a premium as large as 2.1% in that period.

The premium is “a reflection of the cost to trade the underlying bond portfolio,” says Leland Clemons, director of the iShares capital-markets group. Investors should expect to regularly see 1% to 2% premiums in the high-yield ETF, he says, and possibly 4% in times of greater volatility.

When underlying holdings are traded less frequently, or not at all, an ETF’s returns also may diverge from the benchmark it is designed to track. That became an issue for some bond ETFs recently as the Federal Reserve bought up large quantities of agency bonds and mortgage-backed securities, essentially removing them from the market. Vanguard Group recently changed some of its bond index funds and ETFs to benchmarks that exclude these securities purchased by the Fed.

The biggest test of bond-ETF liquidity may be yet to come. So far investors have poured money into these products, and many bond ETFs are trading at significant premiums to NAV. But if investors reverse course and stampede out, the trading could get ugly, experts say. Given the relative illiquidity of many of the underlying bonds, the ETFs could start trading at significant discounts to NAV.

“When everybody tries to get out, it’s going to be a debacle,” says Scott Freeze, president of Street One Financial.

Tips on Trading ETFs

Experts say one simple rule can go a long way toward alleviating ETF trading problems: Use a “limit” order. This means your trade will be executed only within the price range you specify, not at whatever price the market gives you.

To help determine the price you should be paying, check out the ETF’s “indicative” net asset value, which gives an up-to-the-minute look at the value of the fund’s holdings. The iNAV for each ETF is calculated every 15 seconds and is available on sites like Yahoo! Finance or Google Finance. Andrew McOrmond, a managing director at institutional execution-and-trading firm WallachBeth Capital LLC, suggests setting your “limit” slightly above iNAV when buying an ETF and slightly below iNAV when selling it.

One caveat: The iNAV isn’t a useful gauge for international ETFs whose markets are closed while you’re trading.

If you’re looking to do a large trade in a relatively illiquid ETF, consider asking for help, experts say. If your trade will amount to more than 10% of the ETF’s average daily volume, call the ETF provider or your brokerage firm and ask for assistance, Morningstar’s Mr. Burns says.

Investors might also want to avoid trading ETFs at the very beginning or end of the trading day, experts say, when the market can be more volatile.

Finally, with new ETFs constantly hitting the market, investors might not want to dive in as soon as a fund starts trading. “Watch it trade and give it some time to work out the kinks” if you’re concerned about liquidity problems, IndexUniverse’s Mr. Hougan says. “Don’t buy it on day one.”